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Driving shareholder value

It’s always fashionable to muse on the parlous state of capitalism. Seven years ago, it was all broken: financial services run wild had all-but-destroyed our way of life. Four years ago, the Occupy neo-hippies were camping out to find something – anything – as an alternative to the broken promises of the market. A year-and-a-half ago? Thomas Piketty’s algorithmic tear-down of the balance between capital and economic growth.

The reason this topic is such a hardy perennial is that there’s a germ of truth in all these views. The market, untrammeled, is inherently self-destructive. Just look at the issue of tax avoidance. Of course, directors have duties to their shareholders. If there are legitimate ways to minimize tax, they should be used. But finding and aggressively exploiting loopholes can land you in hot water with customers. (And, in any case, the idea you’re legally bound to minimize tax at any cost isn’t true…)

The same is true of supplier relationships. The procurement function is one of the principle protectors of shareholder value. When offered two sources of supply, choosing the more expensive option – and thereby hitting margins, profits and dividends – is quite simply reckless, right?

Well, maybe. But there are some glaring exceptions. Three spring to mind.

When suppliers are in too weak a position to protect their own long-term interests and cut prices to the bone to compete

When suppliers are in a position to offer greater value, but faced with requests for lower costs, minimize their contribution

When buying companies are not joined up and create hidden costs by driving for lower input prices.

Weak suppliers are most obvious in the agricultural industry. Supermarkets get a bad rep for pressurizing suppliers. But when supply is so fragmented, it’s inevitable that prices will fall. As one farmer explained to CIMA for its paper on target cost pricing: “Some farmers will work for lower margins because they are daft. Others just don’t understand their true costs, so they simply undercut their rivals.” When you can tolerate 10% of your suppliers for any one product going bust each year, the incentive to help them manage their own businesses just evaporates. But over time, that can lead to a corrosive culture within procurement – and poor conditions of supply.

The same is true of innovation. Suppliers on paper-thin margins can’t invest in R&D. That’s not simply an issue for a smartphone maker who wants a new breakthrough from their screen provider. What about research into fruit with a longer shelf-life? What about alternative packaging options? If lowest price is your sole criterion, these value-enhancing developments can remain dormant – or, worse, reserved for competitors who see a value in exploring richer supplier relationships.

Both of these can be fixed by addressing the third issue, joined-up thinking internally. Procurement functions need that magic blend of finance, marketing, sales, logistics and HR that can reveal value creation opportunities throughout the business, not just at the point of purchase. A higher unit cost might superficially upset the financial controller. But if that results in better supply timing, more convenient packaging, more marketable finished goods or more motivated staff? It’s an obvious choice.

Some companies do develop this heightened sense of enlightened self-interest. When they’re joined up internally, keen to uncover innovation in their supply chain and eager to manage medium-term risks, they’ll have richer conversations with suppliers. They know those better relationships might mean higher headline prices – but there are big pay-offs. That’s a great carrot.

There’s also a stick. When all these elements unravel, customer and regulator blow-back can be a massive cost. Tesco has been the highest-profile victim, facing investigations not only into financial misstatements caused by over-aggressive booking of “supplier rebates”, but also its supplier relationship policies more generally.

The culture at Tesco isn’t a unique case, and it didn’t emerge out of malice. Pressure to hit financial targets led its teams to fall victim to all the temptations above. Its principle problem was simple: it followed the brute financial logic of the market to its ultimate extent.

There’s nothing wrong with seeking competitive prices. But that pursuit must be placed in a context that protects the long-term viability of your own organization – which these days means your extended supply chain. Shareholders today want growth, they want managed risk and they want steady returns. Over-exploiting suppliers on cost to boost earnings over the short term meets none of those demands.

The lesson for other retailers – and all organizations, for that matter – is simple. While the market is inherently short-termist, driving real shareholder value is a long-term game.